Price Discrimination in Pharmaceutical Companies: The Method to the “Madness”

| April 2, 2012 | 0 Comments

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Pharmaceutical companies, or what critics call “big pharma,” are often condemned for charging prices above marginal cost and price discriminating between different countries (calculating each country’s ability to pay). These practices lie at the heart of feuds such as compulsory licensing, a strategy employed by countries to obtain generic drugs. [1] However, the economics of price discrimination demands a closer look.

One of the primary reasons for price discrimination is the astronomical cost of drug research and development. The total average cost of developing a new drug is more than $1 billion over the course of 15 years of research and testing. [2],[3] Many drugs fail in clinical trials and do not even make it to the market, resulting in sunk costs. A recent study conducted by the Centre for Medicine Research (CMR) on 16 pharmaceutical companies that account for 60% of the world’s research and development spending estimates that Phase II trial success rates have fallen by 10 percentage points to just 18% from 2006 to 2009. Furthermore, only half of drugs make it through Phase III trials. [4] All this is to say that drug development is a high-risk, high-reward game. When the game is won, the rewards have the potential to benefit many lives around the globe in addition to generating the profits that pharmaceutical companies may reap.

Price discrimination can be thought of as a way for pharmaceutical companies to hedge against this huge inherent risk by allowing them to take advantage of the entire market. An August 2011 Health Affairs article affirms that the strategy promotes production of new and existing products by providing money for research and development in the future. Thus, some believe that the long-term benefits of continued innovation outweigh the short-term benefits of more standard pricing. [5]

Furthermore, Patricia Danzon, Professor of Health Care Management at the Wharton School of Business, argues that if pharmaceutical companies are considered monopolistically competitive—a market model in which price exceeds marginal cost in the short-run, but long-run economic profits amount to zero—then price discrimination is not as preposterous as some might suppose. [6] It is important to note that economic profit is different from accounting profit in that the former deducts opportunity costs while the latter does not. This means that when all costs (administrative, time, effort, etc.) are taken into account—not just monetary—profits are zero.

Price discrimination is an attempt not only to recoup research and development costs, but also to make drug prices sensitive to different degrees of price elasticity—responsiveness of consumers to changes in price. Theoretically, the ability to better cater prices to consumers’ willingness to pay means more money for research and development, which in turn fuels the drugs that benefit consumers in the long-run. In other words, for wealthier countries, it makes sense that they are able to pay higher prices for drugs compared to countries with a lower national income.

However, perfect economic theory only exists in an ideal world. For what seems like simple economics on the surface, price discrimination has tangled political implications. Some critics argue that in practice, pricing strategies are not so clear-cut. A different 2011 Health Affairs study, for example, found that some middle-income countries pay higher prices than high-income countries or lower prices than low-income countries. [7]

Perhaps Arthur Pigou’s theory of the different degrees of price discrimination could explain this observation. Pharmaceutical companies use “third degree price discrimination,” which in this case means giving discounts for volume depending on variations in disease burdens among countries. [8] Professor Danzon states, “the controversial discounts are those related to incremental volume or ability to shift market share,” consistent with discriminatory pricing practices. [9]

While the discontent surrounding price discrimination is understandable, this disgruntlement is not necessarily justified by economics. Behind the negative notion of “big bad pharma” lie real people whose goal it is to better the lives of patients around the world on a larger scale than a physician’s clinic. Some critics argue that there must be a way to reduce research and development costs; however, this is yet to be seen. Despite all of their negative connotations, pharmaceutical companies do contribute to the betterment of many lives around the world. At least for now, price discrimination may be one of the few (albeit controversial) methods by which these companies can continue to do so. The economics behind this method is one piece of the larger puzzle.

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Bibliography

[1] Bhanji, Shaira. “Bullying the Boss? Compulsory Licensing for Antiretroviral Drugs in Brazil and Thailand.” Harvard College Global Health Review. Harvard College Global Health Review, 21 Oct. 2011. Web. 11 Feb. 2012. <http://www.hcs.harvard.edu/hghr/2011/10/21/bullying-the-boss-compulsory-licensing-for-antiretroviral-drugs-in-brazil-and-thailand/>.

[2] Cutler, David. EMR20 Policy Exercise 1 – Compulsory Licensing. 2011. PDF. “Empirical and Mathematical Reasoning 20: The Business and Politics of Health.” Harvard University.

[3] “Drug Discovery And Development.” PhRMA. Web. 16 Oct. 2011. <http://www.phrma.org/research/drug-discovery-development>.

[4] Arrowsmith, John. “Phase II Failures: 2008–2010.” Nature 10 (2011). Nature Reviews: Drug Discovery. Nature Publishing Group, 29 Apr. 2011. Web. 19 Feb. 2012. <http://www.nature.com/nrd/journal/v10/n5/full/nrd3439.html>.

[5] Lichtenberg, Frank R. “Pharmaceutical Companies’ Variation Of Drug Prices Within And Among Countries Can Improve Long-Term Social Well-Being.” Health Affairs 30.8 (2011): 1539-544. Health Affairs: At the Intersection of Health, Health Care, and Policy. Project HOPE: The People-to-People Health Foundation, Inc., Aug. 2011. Web. 11 Feb. 2012. <http://content.healthaffairs.org/content/30/8/1539.full.html>.

[6] Danzon, Patricia M. “Price Discrimination for Pharmaceuticals: Welfare Effects in the US and the EU.” International Journal of the Economics of Business 3.3 (1997): 301-21. Web. 11 Feb. 2012. <http://hc.wharton.upenn.edu/danzon/html/CV%20pubs/1997_Danzon_PriceDiscriminationForPharmaceuticals_WelfareEffectsInTheUSandTheEU_InternatlJournalOfTheEconsOfBusiness4.3.pdf>.

[7] Morel, Chantal M., Alistair McGuire, and Elias Mossialos. “The Level Of Income Appears To Have No Consistent Bearing On Pharmaceutical Prices Across Countries.” Health Affairs 30.8 (2011): 1545-552. Health Affairs: At the Intersection of Health, Health Care, and Policy. Project HOPE: The People-to-People Health Foundation, Inc., Aug. 2011. Web. 11 Feb. 2012. <http://content.healthaffairs.org/content/30/8/1545.full.html>.

[8] McAfee, R. Preston. “Price Discrimination.” Issues in Competition Law and Policy. American Bar Association Section of Antitrust Law, 2008. 465-84. Web. 11 Feb. 2012. <http://vita.mcafee.cc/PDF/ABAPriceDiscrimination.pdf>.

[9] See citation 5, page 311.

[10] Global Health Risks: Mortality and Burden of Disease Attributable to Selected Major Risks. Rep. no. ISBN: 978 92 4 156387 1. World Health Organization, 2009. Web. 21 Feb. 2012. <http://www.who.int/healthinfo/global_burden_disease/GlobalHealthRisks_report_full.pdf>.

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